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C211 COHORT
GLOBAL ECONOMICS
FOR MANAGERS
Wade C. Roberts, Ph.D.
Peng Chapter 2

Understanding Formal Institutions:
Politics, Laws, and Economics

Wade C. Roberts, Ph.D.
Education: Economics Doctorate,
University of Utah
Expert Fields: Development,
Labor, Public, Health, Gender,
Forensic Economics

Current Research:
Microfinance, Poverty &
Socioeconomics in Cambodia

“The Success and failure of firms around the globe are determined by firms’ ability to understand and take advantage of the different rules of the game”.

Understanding Institutions…
• What is an institution?
• “The humanly devised constraints that

structure human interaction”
• Douglass North (Nobel Laureate)

Understanding Institutions…
• Institutional Framework
• Formal and informal institutions governing

individual/firm behavior.
• Supported by three pillars:
• Regulatory

• Normative
• Cognitive

Understanding Institutions…
• Regulatory Pillar (formal)
• Coercive power of governments
• Laws, regulations, rules

• Normative Pillar (informal)
• The values, beliefs and actions of a group (emotions)

• Cognitive Pillar (informal)
• Internalized values and beliefs that guide behavior
• Culture & Ethics (logic)
• How do these pillars shape behavior?

Understanding Institutions…
• What is the KEY ROLE of an

institution?
• Reduce Uncertainty!
• Institutions constrain the range of acceptable

actions.
• Uncertainty surrounding economic transactions can lead to transaction costs.
• Misunderstandings and conflicts.

Understanding Institutions…
• Institutions are not static
• Some countries are in transition from centrally

planned economies to market competition (China,
Poland, Russia, Vietnam)
• The “rules of the game” are constantly in flux in all societies. Institution-Based View of Global
Business…
• Two Core Propositions of the

Institution-Based View:
• VIEW 1: Managers and firms rationally

pursue their interests and make choices within the formal and informal constraints in a given institutional framework
• Making decisions in the absence of complete

information (Bounded Rationality)

Institution-Based View of Global
Business…
• Two Core Propositions of the

Institution-Based View:
• VIEW 2: While formal and informal

institutions combine to govern firm behavior, in situations where formal constraints are unclear or fail, informal constraints will play a larger role in reducing uncertainty and providing constancy to managers and firms

Political Systems…
• Formal Institution Categories:
• Political Systems…
• Legal Systems…
• Economic Systems…

Political Systems…
• Formal Institutions:
• Political Systems
• The rules of the game on how a country is

governed politically.
• Democracy
• Totalitarianism

Political Systems…
• Democracy
• A political system in which citizens elect

representatives to govern the country on their behalf.
• Britain has had democracy since the

1200s
• India has the largest (by population)
• Individuals have the right to freedom of expression and organization.

Political Systems…
• Totalitarianism (dictatorship)
• A political system in which one person or party

exercises absolute political control over the population. • Communist totalitarianism: China, Cuba, Laos,
North Korea, Vietnam
• Right-wing totalitarianism (hatred against communism), typically backed by military.
• Theocratic totalitarianism: political power in the hands of one religious party or group (Iran,
Saudi Arabia)
• Tribal totalitarianism: One tribe or ethnic group monopolizing political power (Rwanda).

Political Risk…
• Totalitarianism
• Not as good for business as democracy
• Wars, riots, protests, chaos, breakdowns…
• Political Risk!
• Risk associated with political changes that may

negatively impact domestic and foreign firms.

• Fact: No two democracies have gone to

war with each other.

Legal Systems…
• Formal Institutions:
• Legal Systems involve the formal rules of the

game on how a country’s laws are enacted and enforced.
• The do’s and don’ts are specified, thus

reducing uncertainty and combating opportunism. Legal Systems…
• Three Legal Traditions:
• Civil Law (France, Brazil, China…)
• Derived from Roman Law
• Oldest, most influential, and most widely used

• Common Law (U.S., Canada, Australia…)
• Shaped by precedents and traditions from

previous judicial decisions.
• English speaking countries.
• Theocratic Law (Iran, Saudi Arabia, UAE…)
• Based on religious teachings
• Jewish law and Islamic law

Property Rights…
• Why Property Rights?
• The most fundamental economic function

that a legal system serves to protect is property rights!
• The legal right to use an economic property
(resource) and to derive income and other benefits from it.
• Africa: only 1% of land is formally registered
• Developed countries: every parcel of land,

building and trademark is represented in a property document.

Intellectual Property Rights…
• What is “intellectual”?
• Refers to “intangible” property that is the

result of intellectual activity
• Books
• Videos
• Websites

• Patents (legal rights to inventors)
• Copyrights (legal rights to authors/publishers)
• Trademarks (legal rights to use names, brands,

and designs)

Economic Systems…
• An Economic System
• The rules of the game on how a country is

governed economically.

• Economic Systems:
• Market Economy
• Command Economy

• Mixed Economy

Economic Systems…
• Market Economy
• Invisible Hand (Adam Smith, 1776)
• Laissez faire (hands off approach)
• Factors of production privately owned
• Government intervention limited

Economic Systems…
• Command Economy
• Government takes “commanding height”
• Factors of production government owned
• Supply, demand and price planned by gov.
• Examples:
• Soviet Union
• China

Economic Systems…
• Mixed Economy
• Elements of both market and command

economy
• Relative distribution of market forces vs. command forces.

Economic Systems…
• In Reality…
• No country has ever completely embraced

Adam Smith’s ideal laissez faire.
• No country has ever practiced a complete command economy.
• Economic systems should be seen as

falling somewhere on the “spectrum” between the two extremes.

Drivers of Economic Development…
• What drives economic

development?
• Culture?
• Geography?
• Institutions?

Drivers of Economic Development…
• Culture!
• Rich countries have smarter and harder-working

populations drive by a stronger motivation for economic success.
• Protestant work ethic.

• Question: Are Norwegians 700 times smarter

and harder at work than Burundians?

Drivers of Economic Development…
• Geography!
• Rich countries have natural resources.
• Landlocked?
• Tropical diseases?
• North/South argument.

• Question: How has Singapore done it?

Drivers of Economic Development…
• Institutions!
• Institutions provide the incentive structure of

a society.
• Political, legal and economic systems impact development by affecting incentives and the costs of doing business.
• Gains from trade?
• Specialization?

• Property rights?

Drivers of Economic Development…
• Is a democracy conducive to

economic growth?
• The fastest-growing major economy in the last

three decades remains totalitarian (China).
• India’s (world’s largest democracy) growth rate is about half of China’s.
• 1980’s: 60 countries practicing democracy
• 2000’s: 117 countries practicing democracy

Private vs. State Ownership…
• Private ownership is good!
• State ownership is bad!
• Private owners of capital: Capitalism
• State ownership of capital: Socialism

• Question: Which system is better?

Private ownership

State ownership

Private vs. State Ownership…

Objective of the firm Maximize Profit

Optimal balance for a “fair” deal for all stakeholders Establishment of Entry is determined by entrepreneurs, Entry is determined by government the firm owners, and investors officials and bureaucrats
Financing of the firm Liquidation of the firm Financing is from private sources
(and public shareholders if the firm is publicly traded)

Financing is from state sources

Exit is forced by competition

Exit is determined by government officials and bureaucrats. Firms deemed “too big to fail” may be supported by taxpayer dollars indefinitely. Management appointments are made
Appointment and Management appointments are made by government officials and dismissal of by owners and investors, largely bureaucrats who may also use nonmanagement based on merit economic criteria
Compensation of management Managers’ compensation is determined by competitive market forces. Managers tend to be paid more under private ownership

Managers’ compensation is determined politically and tends to be less under state ownership.

Private vs. State Ownership…
• History…
• The Great Depression was seen as a failure of

capitalism.
• Postwar decades saw an increase in state ownership and a decline in private ownership.

• Question: Was the Great Depression a

failure of capitalism?

Private vs. State Ownership…
• History…
• State owned enterprises rewarded (financially)

managers, rank and file equally.
• Extra work did not translate into extra pay
• Little incentive to improve quality and efficiency. • Soviet employees: “They pretend to pay us,

and we pretend to work”

Private vs. State Ownership…
• History…
• Margret Thatcher (Britain’s prime minister)

privatized capital in the 1980’s.
• Central Europe followed suit.
• Eventually the privatization movement become global. • Washington Consensus

Private vs. State Ownership…
• History…
• Washington Consensus spearheaded by:

• International Monetary Fund (IMF)
• World Bank.

• Core Value: “Belief in the superiority of

private ownership over state ownership”

Private vs. State Ownership…
• History… (2008)
• Pendulum swung back: Massive Recession!
• Governments bailed out failing private firms using

public funds

• Turned them into state owned enterprises

• The U.S. refuses to acknowledge SOE’s,

and instead admits that it has
“government-sponsored enterprises”.
• General Motors
• Citigroup

Private vs. State Ownership…
• Moral Hazard
• “Recklessness when people/organizations do

not have to face the full consequences of their actions. • Capitalism without the risk of failure becomes socialism.
• “Heads I win, tails you lose”.

Private vs. State Ownership…
• State Owned Enterprises
• Represent 10% of global GDP
• Represent 80% of China’s stock market

capitalization.
• 62% in Russia

• 38% in Brazil

• Overall, 9 of the top 15 largest IPOs since

2005 are SOEs

Private vs. State Ownership…
• Beijing Consensus
• Centers on state ownership and government

intervention.

Conclusion…
• Any final questions?

• Thank you for your attendance…

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